Kumiharu Shigehara
Former Deputy Secretary-General and chief economist
of the Organisation for Economic Co-operation and Development

The Japanese economy has been in a protracted phase of
deflation with a large unused production capacity despite monetary policy
geared to virtually zero nominal short-term market interest rates and huge
increases in the monetary base over a sustained period. Accelerated bank
restructuring or further fiscal expansion alone would not correct this
situation.

As pointed out by myself as OECD chief economist in the 1994-95
period of yen's sharp appreciation and argued also by some prominent
US and European
economists including Profs. Allan Meltzer, Jeff Sachs, Joseph Stiglitz
and Lars Svensson, an effective way to jump start the economy after
the burst of a bubble is aggressive easing of domestic monetary conditions
to ward off a deflationary spiral; and once the zero bound to nominal
interest
rates is reached, it is essential for an open economy in a liquidity
trap and recession to resort to another effective stimulative mechanism,
namely
currency depreciation with the understanding and support of its trade
partners.

Between 1993 (a year or so after the burst of a bubble economy)
and last year, Japan's share in world merchandise exports declined
sharply from 10.0 per cent to 6.6 per cent. During the same period, US
share
was remarkably stable at around 11 percent and Germany's remained close
to 10 percent. Japan's poor export performance in the face of weak
domestic demand is largely a result of weaker international price competitiveness
associated with the excessively high yen value. This export behaviour
of Japan is in sharp contrast to that of countries such as the United
Kingdom, Australia and Nordic countries which managed to get out of
recessions
and to solve balance-sheet problems resulting from sharp declines in
domestic real estate and other asset market prices through export-led
recovery induced by sharp currency depreciation. The role of monetary
policy in many of these countries was to contain inflationary pressure
associated with currency depreciation by adoption of numerical inflation
targets together with fiscal tightening to improve budget positions
and prevent the collapse of the government bond market.

In Japan, instead, a series of expansionary fiscal measures
were introduced in vain to reflate the economy battered by the burst
of a bubble and turned its fiscal position into the worst among advanced
countries.
Moreover, despite some short-run ups and downs in the yen exchange rate,
international capital market forces, often unrelated to developments
in price and wage differentials across countries, tended to exert upward
pressure
on the yen exchange rate and it continued to follow an uptrend. Sure,
from time to time, the Bank of Japan as the agent of the ministry of
finance
conducted forceful intervention in the foreign exchange market in an
attempt to avoid the yen's sharp upswings. But, domestic monetary policy
management
and foreign exchange market operations remained un-coordinated and the
yen exchange rate has remained out of line with international price and
wage differentials. Higher nominal wages and other production costs in
Japan than in its partner countries have deterred foreign direct investment
inflows into Japan and encouraged Japanese direct investment abroad with
a result of "hollowing"of Japanese manufacturing industries.

In theory,
at unchanged levels of nominal exchange rates, shaper wage cuts and
other cost deductions in Japan than in its trade partner countries
should help Japanese industries regain international competitiveness
and increase foreign demands for Japanese products, inducing a rise in
business
investment which may in turn raise domestic consumer demand in real
terms, if not in nominal terms, over time. But given a low inflation
environment
in a growing number of competing countries abroad and a certain degree
of downward rigidity of nominal wages and prices in Japan, restoration
of international competitive positions by undergoing a protracted period
of sharper wage cuts and price deflation in Japan is costly. Moreover,
continued deflation and lower nominal income will aggravate debtors'
balance-sheet positions and increase banks' new bad loans. Currency weakening
is a less
costly way of adjustment in particular if supported by actions of Japan's
trade partners which have room for manoeuvre of conventional macroeconomic
policy instruments to offset any undesirable short-run negative demand
effects of Japan's currency adjustment on their economies.

The net effects of a currency depreciation on trade and
current account balances of Japan's trading partners can be very small
over time
with higher export growth jump-starting Japan's domestic economic recovery
and later increasing its import demand. But, yen exchange adjustment
can reduce export volumes and hence aggregate demands in Japan's trading
partners
and have adverse consequences on their external accounts at least in
the short run. Therefore, they might not extend help to Japan unless
they were
fully convinced that Japan's new package deal included measures which
would help increase their own economic benefits over the longer term.

With these
basic domestic and international considerations in mind, I would propose
the following set of policy actions to be jointly taken immediately
by the Bank of Japan and the government of Japan.